July 17, 2008

Two seemingly unrelated events–Tony Snow’s death and the SEC’s banning of short selling of Fannie and Freddie stock–are connected in my mind. And the connection is–Hillary Clinton. No, really. This may seem like a shaggy dog story, but these disparate threads are indeed connected. Bear with me.

In 1993, while I was an Assistant Professor at the Michigan Business School, a small Chicago think tank (now defunct) called Catalyst Institute retained me to quantify the effect of Hillary and Bill Clinton’s speeches and statements about pharmaceutical companies on the prices of pharmaceutical stocks. I did a standard event study, and showed rigorously what everybody pretty much knew; their harsh criticism of drug companies caused an economically large, and statistically significant, decline in the prices of these stocks. Catalyst circulated the study under the title Political Rhetoric and Stock Price Volatility. (I put the study aside, but in 2001 Sara Ellison and Wally Mullins refined the econometrics and published the results in the JLE. Bully for them.)

That’s where Tony Snow came in. He had learned that Hillary Clinton had retained an interest in a hedge fund (!) that short-sold medical stocks. He wrote a nationally syndicated column on the subject, and used my study–and cited me by name–to show that Hillary could have profited from these short sales when her criticisms of the drug industry drove down stock prices. Rush Limbaugh read the column on his program, repeating my name several times.

The story soon developed into a minor controversy. Hillary was subjected to a formal ethics inquiry (which exonerated her.) Vince Foster was working on the matter when he died. This connection injected the issue into the Senate Whitewater investigations–earning me a footnote in the Senate Whitewater Report Part I: The Vince Foster Phase. (All of this probably explains why I was soon an ex-Assistant Professor at the Michigan Business School, but that’s a story for another day.)

Seeking to make political hay of the issue, a group of Republican congressmen asked me to come to DC to explain my study and its implications to them. The group was led by Bob Livingston of Louisiana (later a victim of the Clinton impeachment battle); George Gekas of Pennsylvania; Joe Barton of Texas–and Chris Cox, of California.

I gave an overview of my study, but then the Congressmen called the owner of a small medical device company whose stock Hillary’s hedge fund had sold short. The businessman complained that this short selling had caused his company’s stock to crater, costing him a lot of money. That got Cox rolling. Although supposedly a sophisticated securities lawyer, Cox apparently believed that short selling is an pernicious practice. He went on at some length discussing how short selling was inherently disreputable. I was mildly shocked that a supposedly market-savvy individual would hold such prejudices against short selling.

The impetus for the new rules is purportedly that some short sellers had profited by spreading false rumors about Bear Stearns, and these rumors contributed to the bank’s meltdown. If that’s true, it’s the rumor spreading that is the crime–not the short selling per se–and deserves prosecution. Blanket restrictions on all short selling is overkill. Short selling can actually contribute to price discovery. If stocks are overvalued, informed short sellers can help push them towards a proper valuation. Does the SEC prefer that overvalued stocks remain that way, so that buyers overpay?

Given my 1993 experience with Chris Cox, I have my suspicions that the new short selling restrictions aren’t based on any empirical evidence or deep economic reasoning–instead they are a reflection of Cox’s anti-shorting prejudices (and the prejudices of like-minded folks at the SEC)–prejudices that he displayed in 1993.

But hey, maybe there’s an upside. This could be just the thing to light a fire under single stock futures at ChicagoOne!

[…] I have already taken Cox to task for his dim understanding of the economic functions of financial ma…, but since he won’t go away, I guess I shall have to taunt him a second time. First, shorting is not per se bad. It can make markets more efficient, and indeed, markets where shorting is not possible are more vulnerable to bubbles than those where it is. We WANT markets to reflect bad news too–we want prices that reflect all information, not just happy talk. Second, buying CDSs is often a risk reducing transaction–those long the underlying credit hedge their exposure (as discussed above). Third, although it is possible that someone long a CDS would profit if the price of the underlying instrument declines, or experiences a credit event, and thus may be tempted to do something to cause such a price decline or credit event, if Chris Cox has a particular example in mind, he should share it with the class. Better yet, he should bring an enforcement action. Even if the CDS is not regulated itself, the underlying security would be subject to SEC regulation, and any attempt to manipulate its price would be actionable. (This also shows that the “loophole” is a figment of Cox’s fervid imagination. A manipulation than enhances the profit of the CDS position would necessarily distort the price of the underlying security. This would involve some sort of fraud or manipulation that would fall under SEC jurisdiction. I should also note that creation of large long CDS positions is actually more likely to increase the risk of a squeeze that artificially inflates debt prices during credit events. Well, go figure–I said that 2.5 years ago.) […]